DO Fight The Fed

Today, Wall Street's Professional Investor Class (PIC) waits with bated breath for the Fed to provide words of comfort so that one of Wall Street's revered axioms, "don't fight the Fed", will deliver much needed relief to the beleaguered warriors of finance.

One of characteristic of the PICs that is useful to remember is that they are highly reliant on heuristics - rules of thumb that help frame the world into bite-sized analytical pieces. One of the heuristics that has worked from time immemorial is 'don't fight the Fed". For example, last year, around this time, a well-known hedge fund manager advised investors and traders of this well-worn axiom to great effect and result (stocks rose from the fall of 2010 into the summer of 2011). Unfortunately, while the monetary elixir did work its magic on the PICs (they bought stocks), it had little effect on the real economy.

Never sated, the ever-thirsty PICs are back at the don't-fight-the-Fed troff for another hearty slurp of monetary ease = higher risk asset values. From the PICs and Fed's perspectives, the economic rationale for this view is rather simple: Easy money = an increase in the value of risky assets = a positive wealth effect = increase demand = higher GDP (which then = higher wages, increased hiring, etc, etc). Hence, don't fight the Fed ALWAYS delivers. Or does it? And when it does, is the effect always the same under all conditions? Or are the results a product of the economic and financial times?

It may be a risky thing to go against such a dogma. After all, the four most dangerous words in the investment language is "this time is different". And to assume that more easy money will not produce the above listed outcomes is the speak those very dangerous words. Yet, if one believes we are in times that are truly different, particularly in the post WW II era, then perhaps it's time from some fresh perspectives.

Going against such a well-established dogma of day is also especially dangerous given the changed structure of the market. For, when the momo lemmings (who could care less what the drivers are or what direction the markets are headed, just along as stock prices move) jump on the market trend du jour bandwagon, the wheels get turning rather quickly.

Investment Strategy Implications

If you are going to go against a revered heuristic it is useful to have your own heuristic to counter the revered one. My heuristic is this: in a liquidity trap, the effectiveness of monetary policy is limited, at best. Moreover, monetary ease becomes even more limited when fiscal policy is contradtionary (i.e., expansionary austerity). These global macro forces are strong, pervasive, and global in scope.

So, the PICs may rejoice in what they hear today. And risk assets may rise - for a while. But the global macro forces at work can, and I believe will, overwhelm the monetary elixir the Fed will provide. And the PICs don't do global macro very well. (More on this point in a future blog posting.)

TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many naïve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.

Geithner’s Opening Blunder – China Bashing

As refreshing as the activist tone and tempo of the early days of the Obama administration may be, there is a developing uncertainty as to exactly what is the philosophy of the new administration? Take, for example, the nexus of foreign and economic policy and the comments made by recently confirmed Treasury Secretary Geithner.

What is Mr. Geithner trying to convey when he states that China is “manipulating” its currency? What is the strategy and gamesmanship behind rhetoric that can easily be construed as having a protectionist sound to it?

At a time when the threat of a global beggar-thy-neighbor mindset could develop between and among nations pressured by their citizens (leading to protectionist actions, such as the one the toy industry in India just instituted), it seems quite imprudent for a high US government official in a brand new administration whose philosophy is not quite fully disseminated to be making accusatory statements about one of the world’s most important countries.

The activist tone and tempo of the Obama administration is clearly designed to quickly seek the high ground in the battle to change the game of the political status quo. And who can blame the President. The economic stimulus package is a perfect example of the competing forces at work, with the result almost certainly being the equivalent of an economic camel – a horse designed by a committee. Therefore, getting a jump out of the starting gate does seem to be a rational tactic. However, as shown in business, the first mover advantage may not be sustainable, particularly when so many forces are aligned against change AND the advocates for change may not be completely prepared for all contingencies, including the inevitable unintended consequences.

Investment Strategy Implications

There’s a great moment in the acclaimed HBO series “John Adams” when Ben Franklin advises the volatile Mr. Adams against publicly attacking someone who disagrees with him. “He might think you are serious”, cautions Mr. Franklin. Perhaps the Treasury Secretary should heed such advice. Or, maybe the implied no-drama Obama administration is just a campaign slogan.

Helicopter Hank

“It is like if you are in an airplane and the oxygen mask comes down,” said Stefanie Kimball, (Independent Bank’s) chief lending officer. “First thing you do is put your own mask on, stabilize yourself.”

"In Michigan, Bank Lends Little of Its Bailout Funds"
NY Times, January 14, 2009

The above quote and article captures the essence of the TARP money dump by Helicopter Hank in 2008. This is, no doubt, a large part of the dynamic that has investors worried, but not in the way that may seem apparent.

Under Obama and the Democrats, TARP funds will be allocated in a striking different manner. And this fact justifiably has many investors concerned that a significant increase in bank failures will be a part of the economic landscape this year: something that the accompanying chart from the Economist strongly suggests. Moreover, with no political dynamic at work this year, it is hard envision any scenario in which the second wave of TARP money would find its way to undeserving banks and with such poor transparency and regard for the terms under which such money is made available. As a result, investors should expect that banks with shaky balance sheets are headed for the operational dustbin. And with them, the economic consequences of the deleveraging process will continue unabated.

Investment Strategy Implications

Were it not for the fact that the stock market is deeply oversold, this morning’s 10 to 1 down ratio (both the advance/decline and advance/decline volume) might lead some to conclude that a return to the really bad old days of last year (with 5% + down days, rising VIX levels, banking crisis du jour, and more pain to follow) is underway rather than a second selling climax based on fears well known, defined, and, yes, manageable.

On the assumption that the plethora of money already doled out and what’s in the monetary and fiscal pipeline (including the Fed’s acquisition of selected “toxic assets” and the prospects for bank “write ups”) will have the desired effect of injecting into the US economic body enough juice to trigger the badly needed multiplier effect on corporations and households beginning in the second half of the year, a cautiously optimistic view of equities does seem warranted - at least for the next several months.

Helicopter Hank did what he did and in a manner that only he fully appreciates*. In short order, his actions will be perceived as they should be – a prelude to the real work of restoring the US and global economy to a more balanced era of growth and stability.

*A more conspiratorial mind might suspect there was a political dimension to his largess as 2008 was a presidential and congressional year. Providing “walking around money” to banks who did not qualify under the agreement that healthy banks should receive TARP funds does make one wonder just what was Helicopter Hank thinking?

What if…

…the Keynesian stimulus efforts of President-elect Franklin Delano Obama don’t work?
…credit spreads remain elevated throughout 2009?
…depression/deflation valuation levels come to pass?*

What you see listed above are the three areas I chose to focus on at last Thursday’s 12th Annual "Market Forecast" luncheon. They were selected by me to help frame the discussion among my six expert panelists (Bernstein, Janjigian, Reynolds, Steindel, Trennert, and Wyss)**. Based on the dialogue that ensued, it achieved its goal. Of the three items listed, it was the first, the most macro of the bunch, that generated the most conversation between the panelists and attendees and one that I wish to share in this blog posting.

It must be assumed that some form of fiscal stimulus package will be passed by the US Congress in the coming weeks. By all accounts, the package will have all the qualities of a camel – a horse designed by committee. This is to say tax cuts (for the Republicans) and liberal causes (for the liberal Democrats) will reside along side stimuli that Keynesian oriented economists prefer.

Whatever the blend, there are two larger issues that must not be ignored by investors. The first is embodied in the opening “what if” question – what if the Keynesian stimulus efforts fail to produce a sustainable recovery? At last Thursday’s NYSSA event, panelist David Wyss (Chief Economist, Standard and Poors) articulated what sounded to me like the best answer – the hope that the stimulus package helps unfreeze the private sector (banking, corporate, and personal) and, thereby, a multiplier effect begins to emerge in which a sustainable recovery gets underway. The scary part in this answer is not just the prospect that the unfreezing process does not occur as prescribed but also that the answers David and all five other panelists provided seem to always include the word “hope” – as in “who knows if any of this will have the desired lasting effect?” The second issue is what will be the economic philosophy going forward?***

Investment Strategy Implications

Relative to where things have been recently, the financial markets appear to have entered a somewhat quiescent period. The multi-faceted stimulus and stabilization programs should have their desired effect in the coming months. This is evident in the steady decline in key market metrics, such as the TED spread and the VIX. While still elevated, the direction for the next several months seems almost certainly to be headed in a constructive direction.

The big “however” in this view is what comes after the fiscal and monetary stimulus punchbowl begins to run dry. Then what? For investors, keeping a keen eye on the above and other market and economic metrics will be key to determining if the audacity of our economic hope comes to pass.

*As a point of reference, the valuation parameters noted have been posted on this blog twice in the past weeks (see Dec. 30 and Jan. 7). They provide a framework within which investors can draw their own conclusions re operating earnings for the year ahead and the appropriate P/E ratio.

**Without doubt, given these incredibly challenging times there are numerous areas to explore, many of which could be argued as being vitally important to the investment decision-making process. However, only the most dedicated bottom-up only investor would deny that the global macro climate is the overriding factor is front and center to the future of the markets and economies.

***This is a larger, related issue to the Keynesian stimulus question, one that contains an evolutionary aspect of the current economic crisis: Now that American-style capitalism, in place since the Reagan revolution, has imploded, what will take its place? For interesting and insightful perspective on this subject, see “Where Do We Go From Here”

A Thawny Issue

As noted previously, stocks, having partially recovered from their deep oversold condition, are not the epicenter of the real economy impact of the credit crisis. The credit markets are. And in this regard, as lovely as the big oversold bounce in equities may have been and as astute as any investor might have been identifying the baby thrown out with the bathwater (oil services and global infrastructure, for example), investor focus needs remain firmly on the credit markets.

As of this morning, the TED spread* (LIBOR minus 3 month US Treasury rate) has narrowed some. LIBOR declined but so did the 3 month US Treasury rate. This is not what investors (and central banks) want to see – some improvement in inter-bank lending (lower LIBOR rate) offset by greater fear (lower 3 month US Treasury rate).

Investment Strategy Implications

Equities appear to be in that twilight world of leadership transition where the winners and losers of the next sustainable rally phase (and the inevitable bull market) will emerge. However, as confident as equity investors might and should be re the central banks and governments' actions, it does seem advisable to restrain any large amounts of enthusiasm until more visible signs of the freeze is thawing. In this regards, the credit crisis remains a thawny issue.

*To track the TED spread, click here

Keep Your Eye on the Credit Markets’ Ball

Despite what you may hear in the media, the equity markets are the sideshow. It is the credit markets that hold center stage.

The table and chart below show the yields on various instruments and the TED spread (3 month LIBOR less 3 month US Treasury). When (not if) short term yields begin to rise in US Treasuries and decline elsewhere (specifically LIBOR), then an unfreezing of the credit markets will signal the beginning of the end of the credit panic.

While being mindful of the real economy and the risks of a deep recession, right now it is the credit markets where the focus needs to be placed.











sources: Yahoo! Finance, Bloomberg.com

Unacceptable

As the world listens to Messrs. Paulson and Bernanke argue for support of their three-page $700 billion manifesto, I wish to focus your attention on a central aspect of the credit crisis – the scale and scope of the credit derivatives octopus.

To illustrate, consider this: If scientists can “identify all the approximately 20,000-25,000 genes in human DNA”, and “determine the sequences of the 3 billion chemical base pairs that make up human DNA,” then why can’t the financial scientists identify the extent of the credit derivatives market?

This is a national, if not global, emergency. In such an emergency, is it acceptable to say, “We don’t know what we don’t know?” Or, “It’s too hard to figure out.” Nonsense. If this emergency were a war, would it be acceptable to say, “We can’t build that tank or missile because we don’t know where the steel is”? Of course not. So, why is it acceptable to say we don’t know the extent of the credit derivatives octopus?

Perhaps certain US government officials do know but they are just not saying so. Perhaps those certain US government officials reside in the US Treasury and Federal Reserve Bank. If so, then their actions these past anxiety-riddled months are about as inept as could be possible as a more comprehensive plan of action should have been constructed (from such knowledge) rather than the firemen Hank and Ben put out the latest financial wildfire this weekend, right now routine we have been treated to.

Investment Strategy Implications

Along with the insane decisions to implement FAS 157 and eliminate the uptick rule, the outrageous neglect on the part of those charged with oversight of the entire financial services industry, and the fundamental rationale supporting each (efficient markets and laissez-faire), you can add the unacceptable argument that it’s just too hard to figure out the credit derivatives octopus.

In the process, the world’s markets and economies are now forced to experience a disorderly unwinding of the credit bubble – a disorderly unwinding that could have been mitigated had certain action steps, and the rationales supporting them, been avoided.

Sadly, today’s testimony will almost certainly contain a lot of shoulder shrugging “we don’t know what we don’t know, it’s too hard to figure out” statements. Unacceptable.

Minyanville: Understanding the Panic of 08

This week's Minyanville posting provides a concise review of how things got to where they are and how investors might go beyond their own fears and exploit the panic, including 2 buy recommendations in the infrastructure area.

"The Panic of '08 has nearly every investor convinced that the world is coming to an end. With the financial system shaken to its core, who can blame them? But is the world really coming to an end? Are the "evil doers" on Wall Street getting their just deserts while causing unbearable hurt for the rest of us? Is it time to repent, for the end is near?..."

To read my Minyanville articles including today's posting, click here

Wildfires

It hardly instills deep confidence in our government officials when, after nearly a year, its prime modus operandi is to react to the latest financial crisis with yet another 11th hour solution. This is one of the longer term implications of the bailout plan for Fannie and Freddie.

For all the near term good that could be construed from the latest financial wildfire containment, it is hard to understand why after nearly a year Messrs. Paulson and Bernanke are still in a reactive mode. Given all the resources at their disposal and all the warnings that are plain for everyone to see, it is most disturbing to hear the hurried pitch for unlimited back stop funds for the two GSEs.

Investment Strategy Implications

The Nouriel Roubini scenario where the write-down contagion spreads both up (the quality spectrum, which in the case of mortgages involves Alt-A’s, near prime, and prime) and out (to other categories, such as credit cards, auto loans, and corporate debt) is the nightmare scenario that is threatened by the reactionary mode of government. The economic dangers that $1 trillion (on up) in banking losses would produce cannot be fully measured. But what can be assumed with a fair degree of certainty is that the deleveraging process that such a credit creation contraction would generate will exacerbate an already fragile global economic and financial situation, if not tip the global economy into a depression.

Getting ahead of the curve, being proactive with a well thought out plan would go a long way toward instilling far more overall confidence in financial institutions and, thereby, likely result in stable if not higher asset values (not to mention a better level of consumer confidence).

Putting out wildfires is necessary and helpful but hardly sensible forest management.

Smokey the Bear would not be proud.

Baby Steps

commentary from this week’s “Sectors and Styles Strategy Report”*:

Sunday evening’s US Treasury and Fed actions may seem bold to some. I beg to differ. Here are a few thoughts for your consideration:

A recent report from respected consultancy Bridgewater Associates upped the ante of banking losses to a whopping $1.6 trillion. In consideration of the fact that only ¼ of that number, $400 billion, has been write-off/down thus far was more than enough reason for investors to buy into the panicky feeling experienced these past weeks. For those who like I subscribe to Soros’ reflexivity thesis, the feedback loop to the real economy via a deleveraging contraction is the single most dangerous consequence of the credit crisis (even if the bank loss number is closer to IMF’s $945 billion figure).

As if that weren’t enough, the oil price crisis, with its worldwide inflationary consequences for all countries, is generating demand destruction in developed countries. Here, too, a feedback loop to developing countries presents yet another dangerous outcome to the world economy. Decoupling goes only so far.

These past few weeks, the twin negative forces are being manifested in fear among investors as the valuation inputs from declining earnings and high inflation are producing a dangerous cocktail of lower P/Es and declining earnings that may bring about a stock market decline befitting a super bear.

Investment Strategy Implications

Incrementalism is a product of a belief that what is in place will work. Yes, there may be pain but the tools at hand are the tools that will produce the good result in the end. In the case of the governmental powers that be, that belief is market fundamentalism. This is at the heart of the problem and difficulty in reaching sustainable financial and economic solutions. As long as the Treasury, the Fed, the Administration, and the Congress operate under the rules of market fundamentalism, the actions taken will be like baby steps (such as the Bear Stearns and now the Fannie and Freddie bailouts as well as the Term Facilities to commercial and investment banks) when more serious, more comprehensive, more activist solutions are required.

But let me not restate last Thursday’s blog posting and point to the general market consequences that declining earnings and high inflation will produce.

The following rather simple table provides the P/E levels investors might contemplate should earnings experience even a moderately bad decline from last year’s $82.54:






Does the market fully understand and anticipate such a scenario? I doubt it. More likely shorter-term factors are moving the markets as the dominance by momentum-playing hedge funds produce surges and plunges (mostly the latter of late). Nevertheless, the numbers noted in the above table must not be ignored as its outcome seems more likely the longer market fundamentalism ideology results in baby steps.

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Not So Fine at $4.09

“She’s real fine my 409”
Beach Boys



When the price of gas in the US hit $4.09 a gallon, the song that many consumers began singing was decidedly out of tune from the one the Beach Boys sang many decades ago.

Back in the day, 409 had a different, simpler meaning. Summertime, hot rods, muscle cars, and cheap gas. Today’s tune is, unfortunately, more about demand destruction than it is about how to pick up chicks.

Demand destruction is underway on several levels with high energy prices the central part of the scene. Deleveraging is also playing a major role in demand destruction via credit contraction. Then there is threat of greater regulation and more activist governments.

I have noted this more activist role several times before. And, while the US Congress is in recess this week, recent developments show the increased regulatory threat continues and is broadening. Take for example, the recent surprise announcements re CFDs.

Contracts for difference (CFDs) is a swap instrument that many hedge funds (and no doubt other institutional investors) use to establish positions without disclosing the true nature of the ownership. Within the past few days, however, certain rules changes have been instituted by the Financial Services Authority (FSA) that took most professional investors by surprise. Below are a few links re this story.

Investment Strategy Implications

The world economy is experiencing the dark side of both globalization and financial innovation.

Developing economies, led by China with its policies of excess money creation and subsidies along with hot money flows, continue to provide the demand fodder for high commodities prices, most notably oil. Coupled with capital market flows by major institutional investors away from equities and into commodities (as an asset class, often satisfied via swaps like CFDs), the unsustainably high price of oil will produce one of two high probability outcomes – stagflation (the lite version, most likely) in developed countries or a global recession.

The contraction of financial innovation is also underway as write downs and bail outs force business model changes for financial firms while the consequences of deleveraging produce a substantial cutback in credit creation.

Gas at $4.09 or higher is unsustainable to the world economy. Developed countries can attest to that. So will developing countries, many of whom are heavily dependent on exports to developed countries’ consumers.

The Bank for International Settlements is correct when it declared that the world economy is near a tipping point. For the equity markets, the relevant primary investment question might seem to be “Have the equity markets come to fully appreciate the danger?” In other words, have prices discounted the risks?

I would propose, however, the more relevant question to ask is “Do investors correctly see the complete picture?” In this regard, the answer is more likely no.

409 was in a simpler time. $4.09 is much more complex.

Enjoy the weekend and a happy fourth.

CFD related links:
Article 1
Article 2
Article 3

Beyond the Sound Bite: An Interview with Glenn Reynolds, CFA

"In my interview with the CEO of CreditSights we explored a wide range of factors related to the credit markets including rising corporate default risks, the difference between today's environment (economic and financial) versus 1990/1, confidence levels in the financial system, and an estimation of the credit crisis (we are in the 3rd inning).



All Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Tracking the TAF

Every two weeks, the Fed issues the results of its latest Term Auction Facility. Today’s results (see table*) show a modestly improving trend in the bid to cover ratio – total propositions submitted, total propositions accepted. What is useful is to track the trend since the TAF was instituted last December 17th (see chart*) as it provides a good indication of the progress, if any, in the unfreezing of the core of the credit system (within the primary banks).

Investment Strategy Implications

Credit spreads may be the default tool re the status of the credit freeze. The TAF seems, however, to be an excellent additional tool enabling investors to better understand the status of the freeze. Based on the latest data and its trend, progress is being made but not quite enough as the bid/cover ratio still has a ways to go before it signals that funds accessed through the TAF are no longer vital. A reading closer to 1 would be desirable.

*click on images to enlarge

The Morphine Rally

excerpts from this week's report:
"What a difference a week makes.



Panic set in last Monday as the Federal Reserve sponsored theft of Bear Stearns greeted investors. Billions to millions in a weekend. This week greets investors with the fanciful belief that mountains of liquidity will do the trick. While boodles of money will help alleviate the credit crisis, it will not, however, eliminate the source and core of the problem – excess amounts of credit and the deleveraging process..."

"Last week's debacle in the global markets, commodities, and metals should give every investor pause. Moreover, only three economic sectors managed a positive relative performance week with some (Energy, for example) turning in nasty down numbers for the week. Therefore, understanding the nature of this market rally is crucial to relative performance strength..."

Investment Strategy Implications

"The credit crisis is far from over. In fact, there’s a good chance that many additional cracks in the US financial structure will emerge in the coming months thereby producing more investor angst and the very real risk of spillover into the real economy*. That said, the severe undervaluation that developed over these past months along with high degrees of investor pessimism has set the stage for the rally equities are experiencing.

Equities should continue to close the valuation gap,..."

"...if the US economy were viewed as a sick person afflicted with a potentially seriously debilitating disease, the flood of liquidity looks more like morphine to help alleviate the pain..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

*To gain access to this week's report (and all reports), click on the subscription information link to your left.

“You can’t treat a virus with antibiotics.”

Last Tuesday night I received an e mail from Edith Orenstein, writer for the Financial Executive Internationals Financial Reporting Blog. Edith noticed my blog posting from earlier that day titled “FAS 157: Timing is Everything” and asked if I could comment on the differing opinions from, among others, the CFA Institute on the subject of mark-to-market accounting. In the e mail from Edith were several links on the emerging debate re mark-to-market accounting including one that contained the following recent quotes from Paul Volker:

“I have problems with fair value accounting…”

“…it is evident it doesn’t solve all problems, in fact, it may create a few…especially among financial engineers.” Specifically, he noted, “There is a real question how to blend insights of mark-to-market accounting where there is no market…. and it may lead to exaggerated movements in the markets.”

“There are beautiful theoretical models in economics which impress accountants, [since the Economists] get Nobel prizes, but applied to the real world that don’t work well, [that] is the real challenge.”

Since I am time constrained due to my travels to conduct my final two early 2008 events, I crafted an initial reply to Edith this morning that I wish to share with you here:

Hi Edith,

Before replying to your questions, I want make sure that the core of argument is understood as it hits right at the heart of what constitutes "fair value" and what I consider to be the questionable acceptance that the current price (exit price) for long duration assets such as fixed income instruments (including mortgages) and equities constitutes "fair value".

To begin, nothing captures the essence of my argument better than your quote of Paul Volker:

"There are beautiful theoretical models in economics which impress accountants, [since the Economists] get Nobel prizes, but applied to the real world that don't work well, [that] is the real challenge."

Assets rise and fall in value for many reasons, some of which are tied to the theoretical models Mr. Volker refers to such as the inputs that go into the discounted cash flow model. Such valuation levels reached via these methods are anchored in the rational investor theory as postulated in the "Modern Portfolio Theory" (MPT) and the "Efficient Market Hypothesis" (EMH).

However, recent research in the field of Behavioral Finance has shown what common sense has known all along - investors are not rational at all times and, therefore, are just as easily motivated by non-theoretical factors that are more self interested such as loss aversion and regret.

It is easy to understand why FASB and the CFA Institute are willing to accept the long established dogma of MPT and EMH. Mr. Volker has referenced one reason why. And, in the case of FASB, the threat of litigation as noted by Michael Young of WIlkie, Farr, & Gallagher is, no doubt, a contributing factor. Nevertheless, the fundamental principle underlying price as "fair value" for long duration assets, particularly in a time of deleveraging and capital base impairment (which begets further price pressure on the current price of an asset), is both out of date and at odds with reality (how the markets really work), common sense, and current theory.

I hope this helps clarify my position.

Investment Strategy Implications

“You can’t treat a virus with antibiotics” is an apt description of the current credit crisis. The Fed is clearly attempting to stay out of the theoretical fray of mark-to-market accounting and “fair value” and has referred that role to the FASB with its dogmatic belief in MPT and EMH.

The Fed’s solution to the credit crisis is to produce a tidal wave of liquidity designed primarily to unfreeze the core of the financial system in the hope that it will produce a return to confidence in counterparties and risk assessments and, thereby, prevent future runs on the bank such as that experienced with Northern Rock in Brittan and Bear Stearns in the US. In the process, the Fed hopes its efforts will prevent a spillover of the credit crisis into the real economy. Additionally, the Fed hopes that same liquidity will support the real economy by reducing the interest burden on consumers and business.

Lots of hoping and maybe it will all work. However, two elements at the core of the problem have not been resolved and will not be so simply through more money. One is the aforementioned fantasy of equating the current price of an asset with “fair value”. The other pertains to the consequences of the delevering of the US economy. (This second aspect will be addressed in a future report or blog posting.)

Whenever the economy has gotten into trouble in the past, liquidity acted like caffeine and helped stimulate the body economic. This time, however, liquidity seems to be less like caffeine and more like morphine.

The patient is ill with a virus. That virus is the unwinding of the credit bubble. The false belief that price equals “fair value” (and the “Fair Value Hierarchy”) combined with other factors such as accountants fear of litigation (to be addressed tomorrow) has turned this illness, this financial flu into pneumonia. And neither morphine nor antibiotics will produce the cure. Nor will hoping.

…to be continued.

The US Economy: The Video

If left unchecked, the mark-to-market madness is likely to produce the following effect. (Make sure the sound is on.)



P.S. Is that Bernanke and Paulson at the wheel?

Have a good weekend. (At least try to.)

Fed to Banks: It’s Your Fault

It’s hard to know what it will take for the central bankers of the world to come to the realization that liquidity conditions in the financial economy are in a very precarious position. One central banker, the ECB, seems hamstrung (or is it hidebound?) due to their single mission mandate of maintaining low inflation. Yet, it is the world's primary central banker, the US Federal Reserve, which does have the dual mandate of inflation fighting AND economic growth, that many look to for direction and support.

Since it is the US economy that is the real economy worry to investors, the Fed’s decision making should be understood as best as possible. In this regard, a careful reading of the recent numerous speeches made and congressional testimony given by Fed Governors appears to lead to the following conclusion:

The Fed is walking a fine and dangerous line between being supportive of the liquidity needs of the core of the banking system, the extent to which the US economy will slow, the risks of inflation due to the global growth story, and the moral hazard of bailing out bad banking and financial markets behavior. It does seem rather clear that its policy is to provide as much liquidity as needed to ensure that the core of the system does not collapse while at the same time allowing the market discipline to inflict a (hopefully) manageable level of pain on those who made the bad bets. It is this second part of the game plan that some investors misinterpret. For example,

There appears to be no way to interpret Fed Governor Krozner’s views as expressed this past Monday* other than to conclude that the banks got themselves into this mess and will need to find a way to get themselves out of it. As for solutions, Mr. Krozner notes that international banking regulators are "collaborating to understand the causes of the recent market turbulence and to identify steps to mitigate future problems". (Whew, glad to know that they are hard at work studying the situation.) Then there is his reference to "encouraging banks to maintain more robust liquidity buffers and develop contingency funding plans". Always good to hear words of encouragement.

Investment Strategy Implications

The market discipline philosophy apparently still lives at the Fed. For equity investors, however, the dangerous part of the Fed’s game plan resides in Soros' reflexivity - where the financial economy spreads to the real economy turning a moderate economic decline into a serious recession.

How this drama will play out? Frankly, no one knows as we are in unchartered waters. As for equities, as noted on Tuesday, according to my Expected Return Valuation Model**, stocks currently reflect the deep recession scenario. Should it appear that a deep recession can be avoided, stocks will have the economic justification for a spring rally (listen to the Stovall interview).

*”Liquidity-Risk Management in the Business of Banking”
**subscription required

Mark-to-Market Madness

It’s March, which for college basketball fans means March Madness. In the financial markets, investors are experiencing their own version of madness – Mark-to-Market madness. The idea that nearly every asset that could be priced should be priced and that price represents its fair value is absurd. Let me illustrate with the following example:


Say a homeowner has a fixed rate mortgage. Now let’s say in the mark-to-market world the bank holding that mortgage is able (required?) to continuously determine the asset value of that home based on comparable sales in the area. Suddenly, due to weakness in the housing market, the comparable homes in our homeowner’s area decline in value. What if the bank were then able to go to the homeowner and demand more money as the loan to asset ratio declined below the bank’s requirement? Demand more equity capital for an asset that the market says has declined in value. Mark-to-market in action.

Apparently, the mark-to-market madness has infected the mind of Fed Chairman Bernanke. Consider the following two segments from a recent Bloomberg article, which includes an exchange between Senator Chuck Schumer and Bernanke:

Federal Reserve Chairman Ben S. Bernanke said in congressional testimony on Feb. 28 that accounting rules may be forcing banks to put artificially low values on little-traded assets when they mark them to market. The inability to value such assets on the basis of actual trades, Bernanke said, is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it.''

Later in the article, this:

Bernanke was responding to a question from Senator Charles Schumer, a New York Democrat, who said he had heard "from many people'' that the valuations have been "artificially low.'' That leads to a vicious cycle, he said, in which the writedowns sap bank capital and "they can't do any more lending and everything's frozen up.'' Schumer suggested one response might be to have a six-month grace period on mark-to-market. "You really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it.''

Bernanke didn't buy that idea.

"The risk on the other side is that if you do too much forbearance or delay mark-to-market, the suspicion will arise among investors that you're hiding something,'' he said, adding, "This is really an accounting board responsibility.''

Frankly, I am speechless. I don’t know which is worse – to admit that you have no idea how to fix a serious credit problem or to pass off responsibility of asset valuation methods to FASB. No wonder equity values tanked after the Fed Chairman spoke.

Investment Strategy Implications

If you are unfamiliar with George Soros’ reflexivity principle, I strongly suggest you get acquainted with it. The self-fulfilling nature of reflexivity is the feedback loop between the financial markets and the real economy.

The real economy is set to experience a moderate recession at worst. However, due to reflexivity, should conditions in the financial economy continue to deteriorate driven in large part by mark-to-market madness (thereby generating a graveyard spiral in asset values) the real economy may be in for a deep recession, possibly global in nature, thereby turning the currently extremely undervalued equity markets into a fair value reading.

Unthawing the Deep Freeze

It seems logical that one way for investors to keep an eye on whether the credit freeze has begun to thaw is to track the Fed’s Term Auction Facility (TAF). The data to your left* shows the results for each of the TAF auctions.






Investment Strategy Implications

Along with credit spreads, the TAF results should provide useful data re signs that the freeze at the core of the banking system is beginning to thaw. An unthawing of the credit freeze will be an indicator that some semblance of normalcy is returning to the economy, which should be anticipated by the financial markets.

Based on the TAF data noted, there appears to be no sign that the thaw is underway.

*click on image to enlarge